Description

Porsche is very cheap. The double-whammy of being in both luxury goods and autos has heaped scorn on this stock as the US economy slows and the auto cycle heads downward. But the reality is that this is a de-verticalized manufacturer with surprisingly low fixed costs, a greatly improving product mix, a customer base with a lot of deep pockets, and minimal currency risk. Buyers can look forward to accelerating EPS with a nicely limited downside.

Note: the price I've entered is in Euros (EUR 324)

Before getting into the arguments, let¡¯s review some basic facts. Fiscal year ends July 31. Porsche currently has one main plant in Stuttgart, Germany (aka Zuffenhausen) and outsources a good chunk of production (on the Boxster model only) to Valmet, a third party production plant in Finland. Porsche is currently building a new plant in Leipzig. Shares are traded on the Xetra (German NASDAQ) under POR3. There¡¯s also PSEPF, which is traded on the pink sheets in the US, but these are highly illiquid.

Porsche has two major platforms currently in production, the 911 and the Boxster (which share a good portion of parts in common in order to save costs). When you count all the variations on these two themes, the company is currently offering 10 different cars:

Boxster ¨C entry level roadster (note that all Boxsters are convertibles)
Boxster S ¨C same as above, but with a bigger engine and nicer interior
911 Carrera Coupe and Cabriolet ¨C this is the ¡°classic¡± Porsche. The Cabriolet is the convertible version
911 Carrera 4 Coupe and Cabriolet ¨C same as above, but with full time 4-wheel drive
911 Turbo ¨C the turbo version has been fundamentally redesigned for the 2002 model year
911 GT3 ¨C lightweight, racetrack ready version of the 911
911 GT2 ¨C (New model) the current top of the line car. Even faster than the Turbo (0-60 in 4 sec flat, top speed 198mph)
911 Carerra 4S ¨C (new model) looks like a Turbo from the outside, but isn¡¯t
911 Targa ¨C (relaunched after a few years¡¯ hiatus) cross between a Coupe and a Cabriolet

Porsche is scheduled to launch a third platform in mid-summer 2002, an SUV dubbed the ¡°Cayenne.¡±

Here¡¯s the bear thesis on the stock: the auto business is heading into the wrong side of the cycle in Europe and the US (especially the US) and profit margins could come under pressure in the mid-term, particularly for the high volume manufacturers. Porsche¡¯s US exposure is high and therefore a liability (US accounted for 48% of volume sales, 40% of revenues, and about 60% of profits in FY00). Moreover, Porsches are luxury goods and therefore bound to have unstable demand. Students of history will recall how the company went from boom to bust in the early 1990s, when it faced tough competition and a recession priced many consumers out of the sports-car market. Things got pretty ugly, in fact: Porsche was producing almost 50,000 cars per year in 1986 (60% for the US market). Porsche sold only 23,000 cars in 1992 (18% for the US market).

I prefer the bull thesis because:
1) Customer base is different from that of your typical volume car maker ¨C
a) Unit sales performance is highly model-driven, and plenty of new models are now for sale/coming soon. Current backlog shows that customer response to upcoming new models is very positive.
b) Not to sound snobbish or anything, but Porsche is a niche supplier to largely high-net-worth individuals, not a volume car maker targeting the masses. Basically, a lot of these customers can and will buy even in lean times, as evidenced by the recent demand for the 911.

2) Porsche learned some tough lessons from the early 90s experience, and has since removed/mitigated four of the five drivers behind the early ¡®90s slump:
a) Today as then we¡¯re faced with a slowing economy, BUT:

b) Currency risk is largely mitigated. The dollar lost nearly 30% of its value against the DM from July 31, 1986 to the same date in 1992, with the exchange rate plunging from DM2.09 per dollar to DM1.48. Measured from its high in February 1985 (DM3.45/USD), the dollar depreciated by more than half. Porsche was forced to raise prices (20% in FY87 alone) to offset the lower value of the dollar

Today, Porsche has learned its lesson and hedges more than 90% of its non-Euro profits out for three years. Only about 10% of costs are dollar denominated In FY01 the spot rate was $.90 USD/Euro, while the achieved rate thru hedging was $1.03-1.05 (still highly profitable). (Remember that the spot rate two years ago was as high as $1.08.) For the current year the achieved rate might improve to about $1, then decrease down to about .93 or .94 in FY04. Porsche today can hedge at .92 for subsequent years.

c) Luxury goods tax introduced in 1991 ¨C this has since been repealed and I seriously doubt it will come back anytime soon.

d) Porsche bore the entire production risk back then. Today it¡¯s a de-verticalized manufacturer that shares much of its production risk (and even some development risk) with other manufacturers (more on this later)

e) Mix was heavily weighted toward models with less-stable demand. -- the sales slump in the US mainly hit the lower-priced four cylinder models (the now discontinued 924 and 944 models). As the new entry-level model, the Boxster today is sort-of analogous to the old 4 cylinder 924s and 928s. Mix in FY87 was about two-thirds 4cylinder vs. one-third 911. Mix today is about 50/50 Boxster vs. 911.

Yuppies who had cashed in on the bull market of the 80s became major customers for these entry level models, but turned out to be lousy repeat customers for the newer models when the economy slowed. The 911, on the other hand, typically sells to a more dependable clientele with deeper pockets. Back in the early 90s, the drop-off in 911 sales was a lot less steep than that of the 4 cylinder models. For August and September (FY02 to date), Boxster sales volumes were down 15%, while 911 sales were up 6%. (bear in mind that Sept. 11-30 was terrible for walk-in sales, plus supplies of the new 911s were unusually low due to logistical problems) By the way, Porsche has sworn not to introduce anything at a lower price point than the Boxster.

Moreover, the client base is wider today as compared to the early 90s ¨C sales are now in 75 markets, and fewer sales are made to heavily bonus-dependent professionals. Fewer than 10% of sales are made to the NY area, and banking, media, and IT each account for only 10% of US sales. The demographics in Europe have changed significantly as well.

Also, sales outside of the US and Germany grew at about 24% (17,000+ units) YOY in FY01, and at about 21% in 1H01. These sales are now about 28% of unit volume, so it¡¯s possible that a potential slump in the US would be cushioned by sales abroad.

Also, since some people will have a problem with the general idea of buying a luxury good maker during a slowdown, it¡¯s worth noting that durable luxury items such as jewelry, watches, and cars are generally the less vulnerable part of the luxury goods sector. Porsche¡¯s customer base contains a high proportion of rich folks with stable disposable budgets, as opposed to the more volatile buyer segment of ¡°soft¡±, typically lower-priced luxury goods (e.g. leather and clothing) The big reason here is probably higher resale values. Porsche does really well on this count: a 2-year old 911 sells for about 78% of its original price in Germany, for example (as compared to an average residual value of 58%).

3) Mix is improving dramatically
a) Higher margin vehicles should see strong sales. A plain vanilla 911 generates about four times the EBIT of one Boxster. New 911 variants (GT2, Turbo, etc.) are even better. As mentioned above, sales can be highly model driven, and orders for the redesigned 2002 911 have been very strong. As said previously, Porsche will launch a new SUV called the ¡°Cayenne¡± in summer 2002 (beginning of FY03). This is the big potential growth driver of this story. The Cayenne will be priced close to the entry level 911 and will have similar margins. If this SUV meets Porsche¡¯s expectations, it should roughly double the company¡¯s volumes, revenues, and EPS. After the Sept. 11th tragedy, management said it expects flattish overall volumes for FY02. Since Boxster volumes will clearly fall, this means that the higher margin 911 will be picking up the slack. Management also reiterated that even if volumes fall YOY, earnings growth is expected. Mix and a better hedged rate were cited as factors. There are currently no plans to reduce production targets.

By the way, Porsche uses around 40% of similar parts for its 911 and Boxster models as well as shared engine bases, for example for the Turbo and the GT2. This will probably make it easier to adapt to a changing mix (in addition to saving on R&D costs)

b) Slumping Boxster sales don¡¯t mean that much to profits ¨C Boxster sales will be significantly lower than FY00 for a while, but the margins on these cars are much smaller than those of the 911. (Most of this weakness in sales vs the 911 is probably due to the differences in demographics for Boxster vs 911 customers, but some of it may also be due to the timing of model change-overs. Porsche sales are heavily influenced by introductions of new models. The 2002 911 is a redesigned car, while the Boxster is basically five years old. Porsche will probably introduce a redesigned Boxster in the next two years, which should help sales

4) Unusually low fixed costs limit downside, increase upside ¨C
a) R&D spend will be highly discretionary over the near term -- Porsche accelerated its R&D spend over the past few years and could now cut back without hurting the pipeline. It did this to minimizing reportable pretax profits by taking advantage of tax laws regarding development costs which are soon to be phased out. Annual product spend has been running at a high 8-9% of revenues. This includes in the past two years 300-350DM million in development costs for the Cayenne, which is cost unsupported by existing product revenues. It¡¯s likely that much of the development work on the next generation of 911s and Boxsters may already be done. Given the profit growth anticipated in the intermediate term, Porsche has the option of bringing forward even more future product development to restrain pretax profit growth (and therefore tax expense growth). Hence, management has made some comments about a potential ¡°fourth product¡± (with the Cayenne being the ¡°third product¡±.)

b) De-verticalized manufacturing model -- the Porsche story is a little bit similar to a Dell computer -- core expertise is in design, engine development, brand management and sales, not necessarily in production. About 40% of production is currently outsourced, though Porsche may do the final assembly in house (e.g. Cayenne). This is another lesson learned from the early 90s ¨C back then, this company made cars the old fashioned way: lots of guys sitting around doing detailed work by hand, way too much money tied up in spare parts, etc. They brought in some process consultant from the Japanese auto industry and cleaned up their act. Just as importantly, though, they started to look for ways to outsource some of their production.

Currently Porsche outsources a big chunk of Boxster production to Valmet, a third-party assembler in Finland. The deal is simple: Porsche pays a unit assembly fee to cover all the production costs. Minimum volumes on the contract were cumulative and this minimum was passed some time ago. So now Porsche can reduce Valmet production ¨C to nil if necessary ¨C at just 3 months notice. Of course the company benefits from the Valmet relationship and doesn¡¯t want to screw its partner, but nevertheless this arrangement does a lot to limit the downside of a sales slump.

VW is soon to become the second major outsourcing partner. Porsche and VW will share the Cayenne platform (VW is using it for its own SUV, the Colorado ¨C don¡¯t worry, the cars will be very different and so there¡¯s no concern over brand dilution). Porsche will outsource a large proportion of the body assembly to its project partner (probably about 60%). All told, Porsche will carry only about half of the total project cost.

The proof is in the pudding: due to all this outsourcing (and to premium pricing) Porsche has the highest asset turnover in the European auto industry over the past three years (6X versus the sector average 4X) The main plant in Zuffenhausen is running at 100% capacity, and should stay that way since lowered production will likely come at the expense of partners. Personnel headcount for the past five years has grown at a compounded 6% compared with 22% for production growth.


Risks:
1) Liquidity ¨C Total shares outstanding are 17.5 million, split 50/50 between common and preferred. The Porsche and Piech families own the entire voting common, plus about 13% of the preferred. Thus, float is about 45% of shares outstanding. I¡¯ve flagged this one because I know some of you will consider this a risk. For what it¡¯s worth, my attitude is along the lines of Peter Lynch in ¡°Beating the Street¡± ¨C better to buy great bargains that you might have to unwind slowly, than to buy mediocre stuff that you can sell in a heartbeat.

2) Sale of Valmet could jeopardize Porsche¡¯s contract ¨C following Saab¡¯s planned withdrawal, Porsche will become the sole customer of body assembler Valmet. The Valmet plant, which assembled half of Boxter production in FY00, is underutilized and is up for sale. By the way, Porsche does not plan to shift production from Valmet to the new Leipzig plant once that comes on line. (The Leipzig plant will be used primarily to do finally assembly work for high-end models like the Cayenne and some 911 variants.) Porsche has said that it very much wants to continue the relationship, and that it may outsource an even greater portion of production in the future. Porsche already increased the share of Boxster production done by Valmet to 86% in 1H01.

3) Preferred shares are non-voting. Porsche and Piech families control 100% of voting common. The preferred shares do pay a higher dividend, but it¡¯s only one DM higher. I realize that many will consider this reason to put a haircut on the valuation, but I think this is debatable. There are two risks here, neither of which seem to be a problem currently:

a) The first is that the families run the business to maximize short run cash flow and/or bleed the company to finance their lifestyles. But Porsche clearly seems to be focused on long run profit maximization as evidenced by the current heavy R&D spending. It¡¯s also worth noting that certain models are considered to be sacrilege (e.g. Cayenne, Carerra 4S) by hard-core Porsche enthusiasts who want substance over style but the company is building them anyway because they¡¯re going to be good for profits.

b) The second is that the company gets run by a CEO who is a member of one of the owner families, and turns out to be a bonehead ¨C but keeps his job for too long because he¡¯s family. I could be wrong, but I believe the former CEO was in fact a family member. If so, I think the lesson has clearly been learned. Today Porsche is run by an outsider who has done a great job. (Buffett fans: correct me if I¡¯m wrong but didn¡¯t WEB praise this arrangement (i.e. outside manager overseen by a controlling shareholder) when he was talking about his succession plans?)

Of course I¡¯d prefer one share = one vote. But this company seems to be run with a lot less conflict of interest than many firms with one share class but no controlling investors. Example is the way this company bends over backwards to minimize taxes at the expense of reported income. I realize this partly just a German-thing, but Porsche really seems to take it to an extreme.

4) Increased competition in Boxster customer segment ¨C new offerings are planned by a bunch of rivals (eg Jaguar, Aston Martin)

5) Continued weakness in the overall economy could hurt launch of the Cayenne in summer 2002. But so far, indications are that launch will go well. Porsche originally planned for 20,000, but that number has been revised upward due to a positive response. One sell-side is saying that the Cayenne would be profitable at as little as 5,000 units, but I¡¯ve been unable to confirm this. In any case, the current stock price doesn¡¯t seem to anticipate an even remotely successful launch.

Financials and Valuation:
First off, the balance sheet is in good shape: Cash is about DM1.7 billion, Debt is about DM 300 million, Equity is about DM 2 billion. I would say that at least 0.5 billion DM is excess cash. There are also about DM 1.8 billion of what German GAAP calls ¡°Provisions¡±, which cover warranty, product liability and legal risks, as well as unbilled vendor deliverables and pension obligations. Two things to note here: the risks from these Provisions are basically uncorrelated to the economic cycle, unlike interest bearing debt, so it doesn¡¯t represent the same kind of financial risk as debt if/when sales slow. Second, Porsche is known for being very, very conservative when it comes to provisioning, so this number may be high.

Here¡¯s a few stats in DM (note that I have not backed out excess cash here):

FY2001 FY2002 FY2003
(past FY) (current FY)
Sales 8,042,957 8,355,789 12,019,696
EV/Sales 1.35x 1.27x 0.89x
Sales/share 459.60 DM 477.47 DM 686.84 DM
Price/sales 1.38x 1.33x 0.92x
EBIT 1,011,505 930,100 1,942,972
D&A 454,000 569,000 683,000
EBITDA 1,465,505 1,499,100 2,625,972
EV/EBITDA 7.2x 7.1x 4.1x
EPS (operating) 28.83 DM 29.92 DM 61.63 DM
P/E (operating) 22.0x 21.2x 10.3x
Price/book 5.6x 4.5x 3.2x

ROIC +35.2% +29.5% +43.2%
ROE +28.9% +23.8% +36.5%
Cash ROE +28.9% +23.8% +36.5%

DCF is probably most appropriate way to value these shares given the expanding FCF. I am assuming a somewhat disappointing launch for the Cayenne of 20K units in FY2003, then 25K in 04, 30K in 05. Boxster volumes down 22% next year and don¡¯t rise again until 04. 911 just breaks 30K units in 02. Don¡¯t forget that the tax rate drops to 45% next year due to the new laws. With these assumptions, I think it¡¯s not hard to show that the stock is trading at no more than 60% of true value ¨C not bad for a company of this quality (look at ROIC and consider the brand equity).

One last note: be wary of valuing Porsche on EV/Revenues. With auto stocks, there is obviously a high correlation between EV/Rev and EBIT margin, due to the high levels of fixed costs for most manufacturers. But as has been said, Porsche has a much more flexible cost base than your typical car maker, and thus should not be penalized as heavily when car sales start to slow. By the way, I did not subtract the entire cash balance to get EV ¨C I assumed an automaker would need cash = about 13% of revenues to run its business.

Catalyst

For FY02, profits should grow due to 1) improving mix on flattish unit volumes, lower R&D expense now that Cayenne is developed (partially offset by higher depreciation as capex ramps up as Cayenne goes into production. Over intermediate term, EPS and FCF will grow significantly due to better mix, lower R&D (as % of revenue), lower Capex, and (last but not least) the rollout of the Cayenne.